Back in early October, we wrote a piece titled What Goes Up Must Come Down. The message from that article was clear – when asset prices increase too much too soon, they become prone to reversals which make investors susceptible to losses.

As we mentioned then, these reversals are not limited to asset prices. In fact, everything from major market indices, earnings growth, and economic data are vulnerable to correction when the trajectory is overly bullish, and optimism reaches levels of excess. Fast forward only a few weeks from the release of that article, and it became clear that investors were in a vastly different market environment. Suddenly the market was marked by higher volatility and pessimism, as investors endured a market drawdown of a magnitude not seen in years.

The good news is that the same type of phenomenon also occurs on
the other side — What goes down sharply, can, and often does bounce, at least
temporarily.

Small Cap Stocks

Take the move that we have recently seen in small cap stocks.
After a dismal 2018, small cap stocks started the year taking off like a
rocket. In fact, the Russell 2000, started the first four days of the year by
posting a year-to-date return of greater than 4%. Even European small caps got
in on the act as the MSCI Europe Small EUR Net Total Return Index returned 3% for
2019 through the end of trading Monday.

Source:
Bloomberg

Not bad considering the dismal returns small cap
stocks experienced in 2018. As the chart below shows, the Russell 2000 ended
December down more than 22% from the peak. That small caps have caught a bid to
start the year, is encouraging but truthfully has not developed into a
longer-term trend just yet. It will require a bit more time to see whether
positive momentum in small caps remains with us.

Source: STA Wealth Management

However, the lesson this example provides is that
investors should be less concerned about what has done well in the past and
instead should focus on what is primed to do well going forward. Pretty easy to
say, but unfortunately, very difficult to do because of human biases and our
inherent fight or flight response to things that we perceive as threatening.
And the truth is, there is nothing that feels more threatening to an investor
than deploying capital to an asset that has shown recent underperformance.

Unfortunately, 2018 was a year when most asset classes
finished the year posting a negative return. That means that when it comes time
to redeploy capital, it is likely to feel somewhat uncomfortable.

So what is an investor to do to keep them from sitting
out too long once things settle down and turn more positive?

Source: Novel Investor

There really is no perfect answer. However, what we
have found is that a technical discipline laid on top of a macroeconomic and
fundamental analysis framework can be extremely helpful.

Part of what we do is use short-term exponential
moving averages to help neutralize emotion from the risking/de-risking
decision. For example, as 20-day exponential moving averages cross below the
50-day exponential moving averages on certain broad market indices, it is a
sign to us to reduce exposure. This can be seen in the chart of the MSCI
Emerging Markets Index below. The sell signal (red circle) sent us a signal to
reduce exposure to emerging markets relatively early in 2018. While we did not
reduce exposure at the very peak, it did help us reduce the impact of the steep
decline that occurred in Emerging Markets from April until the end of the year.

Exponential Moving Average Chart – 20/50 days:

Similarly, as the 20-day exponential moving average
crosses above the 50-day exponential moving average, it is a signal to redeploy
capital to this geography to take advantage of an improving price momentum
environment.

While the discipline won’t necessarily get us back in at the very bottom, it should allow us to participate in a major portion of any recovery. Again, it simply provides a tool we can objectively rely on to make capital allocation timing decisions at times when decision-making may otherwise be impaired by emotion.

U.S. Stock Indexes Have January Rebound

Stock prices are trending higher again this morning which continues the rebound that started right after Christmas.

The charts reflect that short-term improvement, while keeping them in a longer-range perspective. The main point of the charts is that all three U.S. stock indexes remain in downtrends as measured by falling moving averages and overhead chart resistance formed during the fourth quarter of last year. The big test will be whether or not prices are able to overcome some of those overhead barriers.

Stock Indexes Approach Overhead Resistance BarriersChart 1, for example, shows the Dow Industrials moving above its 20-day average (green line). But it remains well below more important 50- and 200-day averages (blue and red lines). The Dow is also nearing potential overhead resistance near its early December intra-day low (23,900) and its late October low (24,100). Chart 2 puts those two overhead resistance barriers for the S&P 500 at 2583 and 2603. For the Nasdaq Composite, those two numbers translate to 6878 and 6922. Trading volume has been relatively light which detracts from those recent price gains.

Other Signs of Short-Term Improvement

Other short-term positive signs
include rebounds in economically-sensitive sectors like consumer discretionary
stocks and transports, while defensive stock sectors like consumer staples and
utilities have lagged behind. Small caps are also doing a little better than
large caps over the past week. Bond yields are also bouncing which has caused
profit-taking in Treasury bonds. But corporate bond prices are rebounding,
especially riskier high-yield bonds. That’s usually a sign of renewed
confidence. A pullback in the dollar is also helping lift crude oil and some
other commodity prices. All of those improving trends, however, are short-term
in nature and not enough to reverse technical damage done to the various markets
since the start of the fourth quarter. We will, however, be watching those
short-term trends very carefully in the days ahead to see if they can turn into
something more lasting. Longer-range technical trends aren’t very encouraging.
But we’ll be looking for any signs of those negative trends changing in the new
year. One of the first signs will be how stocks do during the month of January.

Many of you made new year’s resolutions to eat healthier, lose weight and be better to your family. For those of you reading this newsletter, I bet you at least thought about making some Financial “New Year’s Resolutions”. Your friends at STA Wealth want to help you reach your financial resolutions and goals. I was just interviewed by Cameron Huddleston at Go Banking Rate for some New Years Resolution’s that you can consider…at no cost!

On the STA Money Hour, daily at 12pm on 950AM KPRC in Houston, we have talked several times about how to better plan for your future. As we enter the New Year, it is a great time to get organized to start next year on the right foot with the right plan! Below, I have listed some steps that you can take to get your finances ready by year-end.

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by STA Wealth Management, LLC (“STA”), or any non-investment related content, made reference to directly or indirectly in this article / newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this article / newsletter serves as the receipt of, or as a substitute for, personalized investment advice from STA. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. STA is neither a law firm nor a certified public accounting firm and no portion of the article / newsletter content should be construed as legal or accounting advice. A copy of the STA’s current written disclosure Brochure discussing our advisory services and fees is available upon request. Please Note: If you are a STA client, please remember to contact STA, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. STA shall continue to rely on the accuracy of information that you have provided.

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